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4 Tips for Avoiding Financial-Services Fallout

Advice for navigating the mortgage-maddened markets.

The stock market has transformed from Dr. Jekyll into Mr. Hyde, at least in the financial-services industry, leaving investors in a panic. Fools trying to navigate the treacherous mortgage-lending, banking, and financial-services industries might want to consider the following key criteria to invest as safely as possible.

Liquidity, liquidity, liquidityA couple of months ago, liquidity was so abundant that it was almost an afterthought. Need a couple of billion to buy out Stodgy Blue Chip, Inc.? No problem! Just place a quick call to your friendly local investment banker. As long as investment banks like Goldman Sachs (NYSE:GS) or Lehman Brothers (NYSE:LEH) could offload the loans to yield-hungry investors, liquidity was cheap and easy.

Now liquidity is at a hefty premium. In times of turmoil, wealth is often transferred from those who seek liquidity to those who have it.

Take Amaranth, for example. This $9 billion hedge fund has become infamous for losing $6 billion in a single week because of its lack of liquidity. Because it was reportedly employing 8-to-1 leverage and couldn't meet margin calls when the markets moved against it, Amaranth was forced to liquidate. With liquidity, it could've unwound its positions in a more orderly manner.

Instead, deep-pocketed opportunists Citadel and Income Investor recommendation JP Morgan (NYSE:JPM) were more than willing to buy Amaranth's positions at the right price, and ultimately profited. The point? Liquidity is key.

Balanced balance sheet?The best way to judge a company's liquidity is to scope its balance sheet. Homebuilder and Motley Fool Hidden Gems pick MDC (NYSE:MDC) has about $670 million in cash against $1 billion in debt, which makes it far less leveraged than nearly all of its homebuilding peers. A big cash hoard like MDC's is obviously a good sign.

Investors also might want to scour the company's assets and get comfortable with its risk exposures. Additionally, it's always a good idea to search the fine print of a firm's financials for any hints of a blowup, like broken or near-broken debt convenants, off-balance-sheet debt, or other red flags.

Lately, a lot of subprime lenders and hedge funds have gone belly up after having their bank financing pulled. Cash flow is like blood to companies; if it stops, so do they. Beware companies with mismatched assets and liabilities. Longer-term, more stable sources of financing, like long-term covenant-light debt, securitization debt (such as asset-backed securities and collateralized debt obligations), or bank deposits are more stable and better able to withstand financial stress.

Just look at Indymac (NYSE:IMB), a thrift that specializes in Alt-A lending. I won't speculate whether Alt-A loans are the market's next hazard area, but I do think it's fortunate that Indymac gets a large portion of its funding from deposits.

Due to a little mishap called the Great Depression, where mere rumors of a bank's bankruptcy would cause depositors to rush to withdraw deposits, crippling the bank, the FDIC now guarantees that depositors won't lose their money (up to $100,000), even if the bank goes bankrupt.

As a result, most depositors know that the U.S. government guarantees their money, so they won't rush to withdraw their deposits every time a bearish Indymac article is in the news. Thus, deposits make a very stable and low-cost funding source. In contrast, a lender funded by investment banks can have its lines of credit suddenly yanked away; we've seen it happen several times as the current financial contagion spreads.

LeverageA financial-services company usually has a bunch of earning assets, like loans, securities, and cash. It funds those assets through various forms of debt, including deposits, bank loans, and bonds. The difference between those tangible assets and liabilities is the net worth. If your net worth runs out, you're effectively bankrupt.

To quickly estimate a company's margin of error, invert the tangible asset-to-equity ratio (A/E). If a bank has $10 in assets for every $1 in equity, it sports a 10% ratio. If all assets lose 10% of value, then this bank has no more equity, and it's bankrupt. For a 20-to-1 A/E ratio, the margin of error is a smaller 5%. Obviously, leverage increases risk. In other words, if the ratio is greater than 1, a majority of the company's assets were financed with debt. If the ratio is less than 1, a majority of its assets were financed with equity.

(Note: In calculating the A/E ratio, investors must adjust for recourse and non-recourse debt.)

ManagementFinancial-service companies are tricky, because of their leverage, their reliance on estimates, and obscure nature of their businessess. If you can't trust management, then you have no business investing with them. If I were to invest in a mortgage lender, I'd much prefer a company like Countrywide (NYSE:CFC); its time-tested management has been through ups and downs, and retains a big stake in the company. In addition to increasing the intrinsic value of a company, good management also helps prevent embattled investors from losing confidence and selling at or near the bottom.

Putting it all togetherNavigating the financial-services industry can be difficult when credit tightens and liquidity dries up. I've personally seen my portfolio suffer when Mr. Market panicked.

However, when a company meets the criteria listed above, I get interested. A company beaten down by the market, yet still possessing abundant liquidity, a relatively conservative balance sheet, and well-regarded management, would definitely pique my interest.

Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above. Emil appreciates your comments, concerns, and complaints. The Motley Fool's disclosure policy ducks and covers.